Fork-Tongued Fed Needs To Get Its Story Straight

IS IT JUST US OR IS RECENT FED COMMENTARY TRULY BIZARRE?

As Hedgeye CEO Keith McCullough points out in this morning'sEarly Look:

"Following the Fed’s “transparent communication process” can really trip up a Fed follower:

Two weeks ago, Yellen cuts via taking out the rate hikes = #Dovish

Then, for all of last week, her Regional Talking Fed Heads talked up “April and June” rate hikes = #Hawkish

Then she pivots incrementally dovish vs. her teammates’ hawkishness yesterday?"

Here's a look at some recent (i.e. last week!) HAWKISH regional Fed head statements:

Atlanta Fed head Dennis Lockhart said U.S. economic growth has "sufficient momentum evidenced by the economic data to justify a further step at one of the coming meetings, possibly as early as the meeting scheduled for end of April." (3/21)

Philadelphia Fed head Patrick Harker said "I think we need to get on with... This economy is really quite resilient to a lot of the headwinds (including the strong dollar).... I am not a two (rate) rise person... I'd rather see [more hikes this year]." (3/22)

San Francisco Fed head John Williams said the U.S. economy is “looking great” and the Fed would raise rates faster were it not for global factors. “All else equal, assuming everything else is basically the same and the data flow continues the way I hope and expect, then April or June would definitely be potential times to have an increase in interest rates." (3/21)

St. Louis Fed head James Bullard said a case could be made for rate hike in April, sounding a hawkish tone. "The odds that we will fall somewhat behind the curve have increased modestly... We are going to get some [inflation] overshooting here in the relatively near term that might cause the committee to have to raise rates more rapidly later on." (3/23)

"On balance, overall employment has continued to grow at a solid pace so far this year, in part because domestic household spending has been sufficiently strong to offset the drag coming from abroad. Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year.

For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar. Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting.

In particular, foreign economic growth now seems likely to be weaker this year than previously expected, and earnings expectations have declined. By themselves, these developments would tend to restrain U.S. economic activity. But those effects have been at least partially offset by downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending.

For these reasons, I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely be limited, although this assessment is subject to considerable uncertainty."

Yellen also said deflationary pressures on oil prices were "transitory" and the headwind of a stronger dollar would "gradually dissipate."

In other words, Yellen intimates, no worries. But hang on...

Yellen mentioned the word "risk" 19 times during her speech yesterday

Uncertainty was referenced 5 times (the title of the speech, "The Outlook, Uncertainty, and Monetary Policy"

Or how about this acknowledgement of the risks embedded in the Fed's overly-optimistic forecast: "If such downside risks to the outlook were to materialize, they would likely slow U.S. economic activity... For these reasons, the FOMC must watch carefully for signs that the economy may be evolving in unexpected ways."

As we have pointed out before, the phrase "downside risk" is Fedspeak for "I think I probably should lower my forecast, but I'm not sure yet."

[UNLOCKED] Fund Flow Survey | DOL To Put Active Strategies DOA

Takeaway:Active equity strategies continued to struggle in the most recent survey and the forming DOL rules won't help.

Editor's Note: This is a complimentary research note originally published March 24, 2016 by our Financials team. If you would like more info on how you can access our institutional research please email sales@hedgeye.com.

* * * *

Investment Company Institute Mutual Fund Data and ETF Money Flow:

In the 5-day period ending March 16th, three of five active equity mutual fund categories lost funds with large cap equity and emerging market funds seeing the biggest redemptions losing -$1.3 billion and -$1.0 billion respectively. Meanwhile equity ETFs continued their market share advance during the week with +$3.5 billion in contributions. Fixed income allocations snapped back with total bond mutual funds and ETFs collecting +$7.3 billion as investors rebalanced from the 5 week long stock rally.

As if the active business didn't have enough challenges competing with passive ETFs to begin with, the forming Department of Labor Fiduciary rule is decidedly skewed to driving incremental growth into index products. The DOL outlines "conflicted advice" as an active mutual fund distributed by a third party (a broker dealer for example not associated with the fund family) and if those 3rd party funds underperform their benchmark then the new rule gives retail investors (in the retirement channel) the ability to pursue class action law suits against the distributors. Thus, passive ETFs or index funds stand to benefit as a way to circumvent the guidelines, as by definition they can't "underperform." Our Speaker Series call this week with Bob Litan laid out a framework for understanding this policy (see Speaker Series replay HERE).

In the most recent 5-day period ending March 16th, total equity mutual funds put up net outflows of -$2.1 billion, trailing the year-to-date weekly average outflow of -$302 million and the 2015 average outflow of -$1.6 billion.

Fixed income mutual funds put up net inflows of +$4.9 billion, outpacing the year-to-date weekly average inflow of +$793 million and the 2015 average outflow of -$475 million.

Equity ETFs had net subscriptions of +$3.5 billion, outpacing the year-to-date weekly average outflow of -$2.6 billion and the 2015 average inflow of +$2.8 billion. Fixed income ETFs had net inflows of +$2.4 billion, outpacing the year-to-date weekly average inflow of +$2.3 billion and the 2015 average inflow of +$1.0 billion.

Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.

Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the weekly average for 2015 and the weekly year-to-date average for 2016:

Cumulative Annual Flow in Millions by Mutual Fund Product: Chart data is the cumulative fund flow from the ICI mutual fund survey for each year starting with 2008.

Most Recent 12 Week Flow within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI), the weekly average for 2015, and the weekly year-to-date average for 2016. In the third table are the results of the weekly flows into and out of the major market and sector SPDRs:

Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, investors withdrew -$411 million or -5% from the utilities XLU ETF last week.

Cumulative Annual Flow in Millions within Equity and Fixed Income Exchange Traded Funds: Chart data is the cumulative fund flow from Bloomberg's ETF database for each year starting with 2013.

Net Results:

The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a negative -$5.9 billion spread for the week (+$1.4 billion of total equity inflow net of the +$7.3 billion inflow to fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52-week moving average is -$541 million (negative numbers imply more positive money flow to bonds for the week) with a 52-week high of +$20.2 billion (more positive money flow to equities) and a 52-week low of -$19.0 billion (negative numbers imply more positive money flow to bonds for the week.)

Exposures: The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:

RTA Live: March 30, 2016

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Early Look

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RH | Zegna and Wal-Mart Don’t Mix

Takeaway:4Q was a hot mess. But let’s not lose sight of the oppty for RH, the capital being deployed to get there, and the weakening competitive set.

This RH quarter was the equivalent of accessorizing a Zegna suit with a tie from Wal-Mart – it simply does not work. The metrics up and down the P&L and balance sheet were simply bad. We won’t rehash them here. We all know the numbers, and if anybody does not, then rest assured that a 100-day stock price decline from $105 to $38 most certainly does. We think another thing is for certain…RH will look meaningfully different in 12-months than it does today. We also happen to believe that we’ll see tangible evidence – both quantitative and qualitative in each quarter as we go. We like that a lot with the stock trading at a new trough valuation on what we think is the equivalent of a recessionary earnings number (Contact sales@hedgeye.com for our Black Book) and when we’re being pinged more than ever incrementally by value investors instead of the typical growth/garp hedge fund crowd. We can complain about the current valuation, or simply respect it for what it is and act accordingly. This is one of the few transformational growth stories we’ve ever seen in retail (in 20+ years). This is like an UnderArmour, an Ulta, or a Chipotle (sans the e. coli). But not a single one of these – or any transformational story in any industry, for that matter – is a linear progression. There’s usually several stages in any transformational business for reassessing the competitive landscape, identifying the best growth, putting the appropriate capital behind those initiatives (even if shareholders don’t understand it at the time), and…on occasion…screwing up. Well, RH just had such an occasion, and we flat-out reject the premise that the long-term growth vision RH has had along has been smoke and mirrors.

As it relates to the stock, we’ve laid out a path to $300 over the course of three years. Does the latest turn of events change our analysis? Actually, the answer is No – it does not. We still think that RH will realize over $10 in EPS power, and Yes, there will likely be many hiccups as we get there. Does the magnitude of this quarter’s disappointment mean that we should take down our multiple for RH? Over the near-term, yes. But longer-term, absolutely not. When the company achieves our targets – you can rest assured that the Street will forget all about these past three months – just as it has with RH on several occasions since the company went public. Will we ignore the guideposts along the way? No. We’ll scrutinize the P&L and balance sheet six ways til Sunday every quarter as the story plays out. That’s our job, or part of it at least.

But the market does not offer up too many gifts to the investment community. RH with a $3 (4, or 5) handle, is definitely one of them.

SOME CALLOUTS FROM THE QUARTER

1) Inventory: A negative sales to inventory spread is nothing new to RH given its business model, but it’s definitely a red flag in the quarter -- especially given that the revenue miss was associated with a lack of vendor ability to meet demand. To us that means either a) the core product significantly underperformed expectations, or b) RH bought heavily in Modern/Teen categories that didn’t sell. Management all but confirmed choice ‘a)’ on the call, but we think that inexperience in buying Modern/Teen also played a part in the $65mm revenue miss in the quarter. Inventory growth was 30% at years end and DIH was up 24 days into a slowing top line growth equation. We’d be more concerned if expectations weren’t for flat to down earnings growth. But the way we see it, RH now has a low enough margin bar to clear out excess inventory in slow turning core SKUs, which will allow the company to find the right mix between ‘newness’ and core and free up a tremendous amount of working capital – up to $140mm by our math.

2) Incremental margin math: RH is guiding to a $0.22 hit from ‘elevating the customer experience’ in 2016 most of which is loaded into 1H. That is composed of a $15mm reduction in revenue to try to mitigate cancellations, but the $0.22 EPS hit implies a $24mm hit to the P&L. Put another way, that’s an incremental margin of -160%. That means that there are certain other costs loaded into the revenue hit, which we think are both recoverable as we anniversary this headwind next year and will help set RH for the next leg of growth.

3) Design Gallery Performance: Qualitative commentary on the performance of the next generation Full Line Design Galleries has been extremely positive, but we haven’t seen the hard numbers like we saw in the early days of Beverley Boulevard or Houston as proof of concept. Nor should we, as that type of disclosure sets a tough precedent as the number of Design Galleries compounds. But, based on our math the instore performance looks to be at or above the $650/sq.ft. plan the company has spoken to. A few additional details…

In 3Q and 4Q the company comped 10.5%-11% in its full price retail doors, with DTC averaging the total down to a 7% and 9% brand comp in 3Q and 4Q, respectively.

Non-comp Design Gallery square footage amounted to 24% of total square footage in each of the past two quarters, and should (according to management commentary) when fully mature operate at a productivity level of $650/sq.ft. (about 44% of what the company currently does in its existing fleet).

Yet, the company reported sales/average sq. ft. growth of 2.4% in 3Q and -3.3% in 4Q15. Mathematically that doesn’t work unless the new square footage is tracking ahead of plan. Based on our math, sales/sq. ft. (not average sq. ft.) should have been in the $340-$350 range in each of the past two quarters assuming non-comp Design Gallery sq. ft. peaks out at $650 and comes in at a productivity rate of 70%. Instead we saw $363 in 3Q and $373 in 4Q.

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03/30/16 07:47 AM EDT

CHART OF THE DAY: The Final Tally Is In! Earnings Season Sucked

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to learn more.

"... Shifting gears, not that profit or credit cycles matter when the Janet waives her “dovish” day-trader wand, but Earnings Season officially ended yesterday and here’s the summary:

SP500 (500 of 500 companies have reported) aggregate SALES down -4.0%

SP500 aggregate EPS down -6.9%

SP500 Sectors saw 6 of 10 report NEGATIVE earnings growth

“Ex-Energy” (i.e. 40 of the 500 companies), there are still 460 companies!

Janet, We're Up!

“These ideas are entirely imaginary, but if everyone shares them, we can all play the game.”

-Yuval Noah Harari

Imagine US GDP wasn’t tracking towards 1% with most of the cyclical/industrial sectors of the economy in #recession and corporate profits running down -11% year-over-year? Wow. Mind blowing. How would we play the “she’s dovish” game then?

Fascinating and brilliant, this complex market system is, isn’t it? As Harari astutely points out in Sapiens, “in order to establish such complex organizations it is necessary to convince many strangers to cooperate with one another…” (pg 118)

Back to the Global Macro Grind…

It’s almost like 1987 out there right now. Heck, if you asked a perma bull what the US stock market did that year – “it was flat.” After the worst 6-week start to the SP500 ever (which is still, in the non-imagined-world, a very long time), it’s back to “flat”, baby!

If only every portfolio manager’s performance was flat.

As one of the best performing long-only PM’s we work with pinged me yesterday, “bad is good and good is good, but it all sucks.” And since he’s not heartless about how a +1% US “growth” (heading toward 0% in Q2) economy ends for a lot of Americans, he’s right about the sucking part. Once we get through the last of this no-volume-month-end markup, I think bad is going to be bad again.

If you’re long something that is in line with both the Fed and Consensus Macro’s forecast of +3% US GDP growth (some of them used to be at 4%) like say, The Financials, yesterday really sucked too (XLF was only +0.18% on the day to -5.92% YTD).

But, if you were long the real Slower (GDP) and Lower (rates) for Longer stuff, like:

Utilities (XLU) +1.5% on the day

Gold (GLD) +3.0% on the day

Wow, did you have an awesome day. Those returns were 2-4 baggers versus the SPY, bros!

Shifting gears, not that profit or credit cycles matter when the Janet waives her “dovish” day-trader wand, but Earnings Season officially ended yesterday and here’s the summary:

SP500 (500 of 500 companies have reported) aggregate SALES down -4.0%

SP500 aggregate EPS down -6.9%

SP500 Sectors saw 6 of 10 report NEGATIVE earnings growth

“Ex-Energy” (i.e. 40 of the 500 companies), there are still 460 companies!

To give Janet her “fair share” of air time, some of this weakness in the Financials (XLF) “reflected Financial developments since December”, like:

The Fed hiking into a slow-down = December Policy Mistake

The BOJ going for “negative yields” and ECB “buying corporate bonds”

Then the Fed un-hiking the hikes, in their latest attempt to “ease” their SP500 dependent view

You know what all of this did for the credit cycle?

High Yield Spreads (up for 5 of the last 6 days btw) simply made another higher-low within a nasty cyclical breakout (well above the AUG-SEP level). And the rates move all but ensured that bank earnings are going to get hammered in the next Earnings Season.

Yep. Roll out the Old Wall’s “Ex-Financials, Buy Stocks On Rising Gas Prices” bull case for the US Economy in Q2!

Admittedly, we’re all trying hard to play this imaginary game of trying to find the next chart to chase (before the machines do). But it is getting harder to keep track of how the rules of the game go.

Following the Fed’s “transparent communication process” can really trip up a Fed follower:

Two weeks ago, Yellen cuts via taking out the rate hikes = #Dovish

Then, for all of last week, her Regional Talking Fed Heads talked up “April and June” rate hikes = #Hawkish

Then she pivots incrementally dovish vs. her teammates’ hawkishness yesterday?

To be fair, I guess A) the SP500 was down last week (on their hawkishness!) and B) the Atlanta Fed GDP forecast dropped to 0.6% for Q1, so I guess she just had to start moving the goal posts a little faster.

Imagined or not, we all have to keep trying to play this game until the #BeliefSystem breaks down. Since it’s already breaking down in Japan and Europe, I think we’re closer to the beginning of the end of the game than we’ve ever been.

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 1.79-1.91%

SPX 1 RUT 1066-1115

VIX 13.24-19.95 USD 94.54-96.50 YEN 111.02-113.88

Gold 1

Best of luck out there today,

KM

Keith R. McCullough Chief Executive Officer

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